Late fund trades stole from all

Commentary: Legitimate investors were ripped off again

By

NormFosback

Editor's note: Norman G. Fosback is founder and editor of Mutual Funds Magazine and more than a dozen investment letters, as well as author of "Stock Market Logic." He is currently editor of Fosback's Fund Forecaster, a trading-based investment letter published at http://www.fosback.com/.

The scheme gave the traders, mostly hedge funds, a big leg up on securing profits by the time the market closed the following day.

This is the worst abuse in the history of the fund industry.

What was not well reported, and what is still not understood at all by the media or the public, is that the illicit operations were an out-and-out theft of money from every other shareholder invested in the funds. As I will explain below, every penny of profits "earned" by the wrongdoers came right out of the pockets of all other shareholders.

The notion that any privileged investor could exchange shares after the market close, taking advantage of information available following the official pricing of shares, and in contravention of policies extended to all other investors, is unconscionable. It's equivalent to betting on a horse race after it has ended. And it is in violation of Rule 10b-5, the famous antifraud statute of the Securities Act of 1933.

How they did it

Here is how the fraud works: The schemers study market, business, and economic developments after the New York market closes. A price surge in after-hours stock trading or in the equity futures markets (which remain open until 4:15 p.m.) or in other international equity markets, or a favorable business, monetary or economic announcement, triggers the perpetrators into action. They enter a purchase for one or more funds through a securities firm intermediary that backdates the transaction to 4:00, lumps it with other legitimate transactions it took during the day, and forwards it all on to the fund for processing, which (as per industry custom) can be as much as several hours after the market close. Now the perpetrators are in on the action. They know the odds suggest that the new bullish development will have an upward impact on the fund's stock holdings when the market opens the next day. The profits are not necessarily a "lock," but they have a very high probability and, over time, are tantamount to reaping big rewards with very little risk.

A pure theft

But isn't this just a nice deal all around? How does anyone get hurt?

Here's how: While all of the money invested by the perpetrators after 4 p.m. winds up on the books of the fund as of the close of trading that day, the fund's portfolio manager has had no opportunity to invest it. He or she closed down fund operations promptly at 4:00 so the fund could value its shares and simultaneously execute the day's accumulation of new share purchases and redemptions. This means that all of the portfolio gains that accrue over the following 24 hours are earned on the 4:00 p.m. assets of the existing shareholders. None of it is earned on the late money invested by the perpetrators.

Yet when the fund's net asset value rises the following day, all of the gains will be shared by every recorded stockholder in the fund, including the perpetrators. If the perpetrators had not been permitted to belatedly buy shares, the innocent shareholders would have earned all of the fund's gains. Hence, all the profits earned by the perpetrators reduces the profits earned by the other shareholders, dollar for dollar.

Lastly, the perpetrators close out their trade the day after they bought and walk away with the other shareholders' just gains. As pure a swindle as it gets. Robbing a fund turns out to be just as lucrative as robbing a bank, but a whole lot less risky. And every bit as illegal!

What will happen now

Class-action lawsuits are piling up quickly on behalf of millions of mutual fund shareholders. We have no doubt that state and Securities and Exchange Commission auditors and investigators will scour the operations of every mutual fund family in America to uncover all such abuses. Fund sponsors will be pressured by the industry and the commission to reimburse funds and their shareholders for the losses involved. Heads will roll and lawsuits will fly on this one, as the industry scrambles to restore its squeaky-clean reputation -- alas, a rep that will never again be quite so sparkling.

The bad news is that some fund families may needlessly tighten trading deadline times and minimum holding periods required for perfectly legitimate fund transfers by innocent shareholders. You should vote against any such proposals that may be presented to you by proxy at annual or special fund shareholder meetings. All that is really required by the funds is curtailing special-privilege treatment to certain individuals and investment pool operators trying to gain trading advantages. It follows that you must keep your eyes open for changes in policies at individual funds in which you have investments.

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